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Petrofac has reported trading in line with guidance, with progress on reducing costs and disposing of non-core assets. The order book continues to shrink, despite an improving market outlook, and the group finished November with a modest net debt position.

Our view

Petrofac's order book has continued to shrink, and while the group's done a good job of cutting costs, the shortage of new projects is starting to restrict management's room for manoeuvre. A series of less profitable contracts in the core construction businesses means margins are under pressure and the shrinking order book looks set to exert pressure on revenues in 2020.

The sale of Petrofac's own oil & gas assets makes winning engineering contracts all the more critical, and even the best management team will struggle to grow profits if there's no work to do.

The good news is that the wider market is looking much more positive, and that means the tendering pipeline is more promising. With $39bn of projects up for grabs next year, there's plenty of opportunity to replenish the pipeline.

However, converting leads to contracts has been a struggle recently. The group landed just $1bn of $13bn of tenders in the second half of the year. While no charges have been brought against either the company or any current employees, we suspect the ongoing Serious Fraud Office (SFO) investigation is a major factor. Management comments at the half year suggested that's particularly true in the key Saudi Arabian and Iraqi markets.

Petrofac would likely face a significant cash fine were it found to be at fault, and that would raise questions about the sustainability of the dividend, despite the low level of debt on the balance sheet. That probably explains why the stock currently offers a prospective yield of 7.8%. Investors are worried the cash could dry up at short notice.

Putting the SFO investigation to one side - which is essentially out of the company's hands now anyway - the key near term test is whether the order book can return to growth over the next 6-12 months. Unfortunately that relies on customers putting the SFO investigation to one side too.

Trading Update

Petrofac has added $3bn of new orders so far this year. However, that failed to make up for work completed, as the total backlog shrunk from $9.6bn at the start of the year to $7.4bn at the end of November, down from $8.6bn at the end of June. The group is currently bidding on $39bn of work due for award in 2020.

Revenue and net margins in the Engineering & Construction business are in line with guidance. The division is approaching completion on projects in the North Sea, Malaysia, the UAE, Saudi Arabia and Kuwait and has started work on the Al Taweelah Alumina Refinery in the UAE. The division has secured $2bn of new work year-to-date, with project wins in Algeria and Oman.

Engineering & Production Services is performing in line with expectations, with a recovery in wider market conditions providing a boost in the second half. The division secured $1bn of new contracts across the UK North Sea, Oman, UAE, Malaysia and Azerbaijan. The division recently entered the US onshore market with the bolt-on acquisition of W&W Energy Services.

Production in Integrated Energy Services fell to 4.2m barrels of oil equivalent a day (2018: 6.2m). That's in line with management expectations and reflects divestments made last year.

Full year revenue is expected to be around $5.5bn, but this expected to decline in 2020, reflecting the lower new contracts wins in recent years.

Petrofac expected to finish the year with net debt of around $0.1bn, compared to $0.1bn net cash at the start of the year, reflecting lower order intake and some delayed payments.

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